Modern electronic trading systems have been developed for permitting electronic trading of various forms of securities. Electronic communications networks (ECNs) are electronic trading systems that can automatically match buy and sell orders at specified prices. Typically, such trading systems permit large institutions, such as banks and security dealers to electronically post limit orders, i.e., bid and ask prices, for tradable items. The presence on the trading system of such posted rates provides liquidity to the trading system to, in effect, “make the market.” Thus, such participants are referred to as liquidity providers or market makers. Generally, the orders posted to the system by the liquidity providers are visible, persistent orders, that is, they are visible to other traders, and stay on the exchange's book of dealable orders until they are aggressed upon, i.e., hit or taken by liquidity consumers, unless they are withdrawn or modified before being hit or taken. In a typical scenario, the book of orders visible to consumers displays the available orders with the best available prices of remaining orders towards the top of the book.
Market makers orders that will be displayed in the system until the full quantity of the order is matched by one or more counter-orders and result in trade(s), or until the order is cancelled or modified by the market maker. Orders that are displayed on the order book are referred to as passive orders. Liquidity consumers have access to the book of orders currently on the system, for example via an electronic display showing all or part of the order book, the information of which is provided to the consumer by electronic communication with the trading system. Consumers can place orders that match with existing orders in the system. Orders are always matched at the passive order price, with earlier orders getting priority over the orders that come in later.
The currency market represents one of the world's largest financial markets. One reason investors purchase foreign currencies is to manage foreign exchange risk exposure. For example, United States residents going to visit a European country on vacation have the risk that if the Euro (EUR) appreciates against the United States Dollar (USD), their vacation will be more expensive. Exporters who sell products in foreign currency have the risk that if the value of that foreign currency falls, then the revenues in the exporter's home currency will be lower. An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate and make the local currency cost greater than expected.
Fund managers and companies who own foreign assets are also regularly exposed to changes in currency exchange rates. For example, a mutual fund manager who purchases foreign securities in a foreign currency for a mutual fund that is traded in a home currency must take into account fluctuations in currency exchange rates in managing the assets of the mutual fund. A large number of investors also invest in foreign currencies for speculative purposes, i.e., to profit from accurately predicting changes in currency rates.
In every foreign exchange transaction, one currency is purchased and another currency is sold. The currencies that are purchased and sold in a foreign exchange transaction are also referred to as a currency pair. A currency pair consists of a base currency and a reference currency. EUR/USD is an example of a currency pair. In this example, the base currency is EUR and its value remains constant at one EUR. The reference currency is USD. The value of the reference currency fluctuates up and down relative to the base currency. For example, if the EUR/USD currency pair is quoted at 1.1500, it means that one EUR costs USD 1.1500. Likewise, if the EUR/USD currency pair increases to 1.2000, the same EUR is now equivalent to USD 1.2000.
Currency transactions can be quoted in one of two ways: American-terms, in which a currency is quoted in terms of the number of United States Dollar per unit of foreign currency (e.g., how many USD to buy 1 EUR), and in European-terms, in which one United States Dollar is quoted in terms of number of units of foreign currency per dollar (e.g., how many Euro to buy 1 USD). The same logic can be applied to currency pairs in which the USD is not one of the currencies. Either currency can be expressed in terms of the other. However there are generally accepted conventions in the inter-bank foreign exchange marketplace that have been adopted by most of the foreign exchange marketplace. For example, the EUR/USD pair is quoted in American Terms and the Swiss Franc is quoted in European Terms.
In currency trading, a long position refers to entering into a contract to buy a base currency in exchange for a set amount of reference currency at a set time in the future. A trader may speculate that the price of a base currency will increase relative to the value of the reference currency by entering into a long position. A short position in currency trading means that the trader has entered into a contract to sell a set amount of base currency in exchange for a set amount of reference currency. A trader may speculate that the price of a base currency will decrease relative to the value of the reference currency by entering into a short position.
Foreign exchange (FX) transactions are offered as FX spot transactions or FX forward transactions. FX spot transactions are exchanges of one currency for another for immediate delivery. FX spot transactions are conducted at an exchange rate for immediate delivery known as the spot rate. Immediate delivery in the spot market is generally two business days, which is called the value date. The two day settlement period is necessary to allow for trade processing and for currency payments to be wired around the world.
FX forward transactions are exchanges of one currency for another at a future date. FX forward transactions are conducted at a forward rate, which is the exchange rate available at the time of the purchase of the FX forward transaction for exchanging currency at some specified date in the future. The forward rate is a function of both the spot rate and the difference in interest rates that could be earned in money markets or bond markets in the respective two countries. The difference between a forward exchange rate and a spot exchange rate represents the benefit or disadvantage an investor would experience should they convert in the spot market from one currency represented in the pair to the other and hold the new currency earning interest at a risk free rate. To the extent that there is an economic advantage associated with a higher interest rate in the new currency, such advantage is reflected in the price of the FX forward transaction. The discount or premium to the spot price in an FX forward transaction of the same pair is typically referred to as the “carry” or “cost of carry.”
The foreign exchange market operates five days per week on a 24-hour trade date basis beginning at 5 p.m. Eastern Standard Time (EST) Sunday. A trading day begins at 5 p.m. EST and ending the next day at 5 p.m. EST. For example, on a Monday, spot currencies are trading for value on Wednesday (assuming no holidays). At 5 p.m. EST on Monday, the trade date becomes Tuesday and the value date becomes Thursday. A position opened on Monday at 5 p.m. EST is either closed or rolled over to the next value date before the end of trading day on Tuesday. In this example, a one-day rollover involves the open position being rolled over from a value date of Wednesday to that of Thursday.
Rollover transactions are effectuated by making two offsetting trades that result in the same open position. However, when making rollover transactions, the rate at which a currency pair is quoted can change. These changes represent the difference in interest rates between the two currencies in the trader's open position applied in currency-rate terms (i.e., one day of “carry” or “cost of carry”). They constitute net interest earned or paid by the trader, depending on the direction of the trader's position. Assuming there is no change in the spot exchange rate for the currency pair, a trader can earn money in a rollover transaction if the trader holds a long position in the currency with the higher interest rate and holds a short position in the currency with the lower interest rate. Conversely, a trader can lose money in a rollover transaction if the trader holds a short position in the currency with the higher interest rate and holds a long position in the currency with the lower interest rate.
Exchange traded funds (ETFs) offer public investors an undivided interest in a pool of securities or other assets and thus are similar in many ways to traditional mutual funds, except that shares in an ETF can be bought and sold throughout the day like stocks on a securities exchange through a broker-dealer. Unlike traditional mutual funds, traders and investors participating in a secondary market can buy and sell ETFs without having to redeem their individual shares at net asset value, or NAV. Instead, financial institutions or other qualified investors purchase and redeem ETF shares directly from the ETF in the primary market, but only in large blocks. In the case of currency ETFs, financial institutions or other qualified investors convert currency holdings to shares that trade in a publicly tradeable marketplace. It is recognized these have been developed and are substantially different from embodiments of the present invention.
In 2005, Rydex Investments launched the first ever currency ETF called the Euro Currency Trust (NYSE: FXE) in New York. Since then Rydex has launched a series of funds tracking all major currencies under their brand CurrencyShares. In 2008, Deutsche Bank's db x-trackers launched Sterling Money Market ETF (LSE: XGBP) and US Dollar Money Market ETF (LSE: XUSD) in London.
Currency ETFs do not require rollover transactions to maintain currency positions, but they have disadvantages inherent in their structure. Currency ETF shares are priced to the foreign exchange rate plus interest, which creates tracking error from the currency price being traded. They also do not trade on the 24 hour per day trading cycle of the foreign exchange markets and are therefore more difficult to redeem. They also are quoted in a convention not consistent with the interbank market and with settlement periods not consistent with the foreign exchange interbank market. For this reason, they may have a value that may track the value of currency but cannot be considered fungible with spot FX contracts or forward contracts. Their lack of fungibility means they suffer from far less volume, less institutional participation in trading and price discovery and have greater risk of price tracking error Inherently, Currency ETFs are not an efficient vehicle to trade currencies or baskets of currencies as a security.
Currency ETFs also have disadvantages in the way that interest is paid. With currency ETFs, interest is earned in a reference currency and then converted into the base currency at some unknown rate close in time to the date on which dividends are paid (typically monthly) and then distributed to shareholders, which exposes currency ETF investors to additional foreign currency exposure on accrued interest.
There are also currency Exchange Traded Notes (ETNs) that have been developed. ETNs are debt securities backed by an issuer that are designed to provide investors access to returns of various benchmarks. Though linked to the performance of a market benchmark, ETNs are not equities or index funds, but they do share several characteristics of the latter. Similar to equities, they are traded on an exchange and can be shorted. Similar to index fund, they are linked to the return of a benchmark index. But as debt securities, ETNs do not actually own anything they are tracking.
There are currency ETNs that have been developed to attempt to provide investors with returns of certain currency benchmarks. But currency ETNs are subject to risk of default by the issuing bank as counter party. Currency ETNs also share many of the same disadvantages of currency ETFs, including that currency ETNs have disadvantages in the way that interest is paid and the way it is included in the price of the instrument making it more difficult for the trader to determine the accuracy of the instruments' tracking of the value of underlying assets, they are more difficult to redeem (they can be redeemed only in the primary market), and are not fungible with FX spot and forward transactions. This is due to the fact that an ETN is redeemable in the primary market for an amount equal to an index—making the ETN very accurate at tracking the index but this index may temporarily diverge in value from the underlying asset it seeks to track thus marking it more difficult to arbitrage price to the actual underlying asset. To effect such a price arbitrage, the trader would have to add an extra step of arbitraging the price of the index to the underlying assets it seeks to track thus adding complexity and cost to the process.
The global FX marketplace is estimated to transact over four trillion USD per day. Much of that volume is concentrated on a few pairs such as the EUR/USD, and USD/Japanese Yen. Rather than one centralized regulated marketplace, the global FX market consists of many fragmented, unregulated, over-the-counter pools of liquidity which can range from a single counterparty-to-counterparty market to a pool of liquidity providers competing for order flow from liquidity takers in an electronic order matching electronic network. The nature of the fragmentation of the global FX marketplace means it is possible that a single currency pair can trade at different prices, in different markets at the same time. It is desirable for the purpose of price transparency, liquidity and market confidence to provide methods and systems to attract traders for purpose of transparent price discovery and to add liquidity to the global FX marketplace, especially in currency pairs that do not enjoy the liquidity that exists in major currency pairs such as that of the US Dollar, Euro and Japanese Yen.
In the foreign exchange market, there are many liquidity pools each comprising an electronic communications network (ECN) operated based on credit and trading relationships. These pools may be created and sponsored by liquidity providers, for example, market makers that are sizable holders of positions in particular currencies that facilitate the trading of those currencies to investors seeking to transact in currencies, who are liquidity consumers. These liquidity pools by definition have built-in biases.
As discussed above, liquidity providers are sometimes referred to as market makers because they “make the market” by providing persistent orders, i.e., passive orders that rest on the book of orders (i.e., the record of unexecuted limit orders placed on the system), and which are visible to at least some traders on the trading system that corresponds to the liquidity pool. The terms “liquidity provider” and “market maker” will be used interchangeably throughout this description.
In the present application “orders” will be used to refer generally to submissions of either bid or ask prices, each of which is a type of order. Liquidity consumers, sometimes referred to as “market participants,” react to orders visible to them, e.g., on trading terminals, by submitting aggressive orders hoping to hit or take the orders they see on their terminal. An aggressive order submitted by a liquidity consumer is sometimes referred to as an “invisible” order, because unlike a passive order from a liquidity provider, an aggressive order generally will not become part of the book of orders visible to traders, although an ECN's rules may permit market participants to submit passive orders to the system as well.
Because circumstances may change between the time a liquidity provider's order appears on the order book and the time at which the order is hit or taken by a liquidity consumer, the liquidity provider is vulnerable to changes that may worsen its position with respect to the market during that period of time. For example, prices in the overall market may undergo rapid changes in one direction or the other, such that the previously submitted orders, if hit or taken by a liquidity consumer, would result in a disadvantageous transaction for the liquidity provider.
Thus, if a liquidity provider believes that the price of a security is about to go up, the provider may wish to, e.g., cancel its sell order at, say, $20 and raise it to $20.10. Moreover, liquidity providers wish to participate in a market place with customers with legitimate trading interests, customers that would not try to manipulate the market or try to run latency arbitrage models. Liquidity providers also wish to protect themselves against high frequency trading shops. To provide protection to liquidity providers from these disadvantageous occurrences, and to persuade them to participate, it is common in spot foreign exchange trading systems for liquidity providers to be provided with a “last look” option where liquidity consumers have to submit trade requests based on a tradable price published by a liquidity provider, but must give the liquidity provider a chance to accept or reject the trade.
While the last look option may be in the interests of liquidity providers, from the point of view of the liquidity consumer, a system that implements a “last look” functionality might not be considered optimal. Liquidity consumers are seeking a market place in which published prices are executable, verifiable and sufficient liquidity is available at all times. To the liquidity consumer, the ability of the liquidity provider to renege on an order after it has been hit or taken by the liquidity consumer can result in a “pricing mirage” in which, in spite of the fact that a price was published, the consumer may not actually have the opportunity to trade on that price. This can result in consumer uncertainty, wasted time, and possible missed opportunities, in placing orders that are never executed.
In order to ameliorate some of the perceived disadvantages of the last look, trading systems such as Currenex and HotspotFX permit consumers to filter out from their visible book of orders any orders placed by liquidity providers that are permitted to execute a last look. However, while this removes some of the disadvantages, at least from the point of view of the liquidity consumer, of the “last look,” it is in effect a “band-aid” approach to solving the problem that does not take into account the legitimate concerns of all parties involved. In addition, since most of the liquidity providers opt to have the last look option, filtering these orders out would leave a liquidity consumer with limited available liquidity at best, or with no available liquidity at all. Also, liquidity providers that do provide liquidity without the last look option tend to do so with less consistency and either remove their prices or increase the spreads between the bid and offer orders they post at the time of high volatility in the market.
Thus, there exists a need for a trading system that provides liquidity providers with a way of ameliorating their risks while at the same time permitting transparent and efficient trading for consumers.